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Monday, November 3, 2014

Flash Boys

You wouldn’t think that a book about high-frequency stock trading could be a compelling read, but Michael Lewis’s story-telling skills make his book Flash Boys a page-turner even for readers with a modest knowledge of stock trading. I’ve read several articles explaining high-frequency trading (HFT), but Lewis weaves much clearer explanations in with the stories of the people who set out to stop high-frequency traders from exploiting the rest of us.

The book describes many ways that high-frequency traders get an unfair advantage, but the biggest problem was a form of front-running. Stock trades often get split up among different exchanges because no one exchange is offering enough shares to fill the order. High-frequency traders would place “very small bids and offers, typically for 100 shares, for every listed stock. Having gleaned that there was a buyer or seller of Company X’s shares, they would race ahead to the other exchanges and buy or sell accordingly.” So, whichever exchange the split up order arrived at first would tip off the high-frequency traders, and they were able to get to other exchanges so fast that they could trade ahead of the rest of the split up order.

This ability to front-run is disturbing enough but high-frequency traders also have an incentive to create unstable markets. The more that stocks prices change in a fraction of a second, the more money they can make from knowing the new price before everyone else.

Lewis explains convincingly that stock trading is rigged, but it’s likely that many readers would come away with an overly pessimistic view of stock ownership. When Lewis says that high-frequency traders are “removing money from the pockets of investors large and small,” I think he should make a better distinction between “traders” and “investors.”

High-frequency traders take money from you when you trade or your fund manager trades on your behalf. They aren’t taking any money from you while you’re just holding stocks. Of course, you have to trade sometime if you’re going to own stocks, but you can control how often you trade.

To day-traders, the cut high-frequency traders take is like a scalping, but for investors who hold their stocks for 5 or 10 years or longer, the HFT cut reminds me of the complaint about a sandwich that is stingy on the ham: “the pig never even felt the slice coming off its arse.” Investors can control the size of the HFT cut over the course of a year by avoiding too much trading and avoiding buying funds whose managers trade too much.

With that one criticism about the distinction between trading and investing out of the way, I’ll move on to some of the good points of this excellent book.

The book opens with a description of a group building a straight fiber-optic connection that gave the fastest data path from markets in Chicago and New Jersey. They proceeded to sell access to the link to 200 firms for $10.6 million each. One buyer was so interested in gaining more exclusive access to the link that he came back with only one question: “Can you double the price?”

An unlikely group decided to create a new stock exchange (IEX) with the goal of preventing HFT abuses. One of their challenges was preventing high-frequency traders from moving close to the exchange to get a speed advantage. Their clever solution was to “coil thirty-eight miles of fiber and stick it in a compartment the size of a shoebox to simulate the effects of the distance.”

When the people at newly-formed exchange, IEX, analyzed their trading data to see which brokers were following the rules and which were abusing their clients, it turned out that only 10 of 94 were client-friendly.

Some might argue that the actions of high-frequency traders are just capitalism and that Lewis is against free markets. This isn’t true. He makes the distinction as follows:

“It’s healthy and good when traders see the relationship between the price of crude oil and the price of oil company stocks, and drive these stocks higher. It’s even healthy and good when some clever high-frequency trader divines a necessary statistical relationship between the share prices of Chevron and Exxon, and responds when it gets out of whack. It was neither healthy nor good when public stock exchanges introduced order types and speed advantages that high-frequency traders could use to exploit everyone else.”

I highly recommend this book. I hope readers conclude they should choose an investment strategy that minimizes trading rather than concluding they should avoid stocks altogether.